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Prediction, Day Trading, and Confirmation Bias

Why do most day traders persist, despite a lack of success?

I’ve listened to several day traders speak at length about their progress, and heard a common thread: in explaining their slow progress, they speak of the difficulty of mastering their emotions. The traders don’t know each other, but they follow the same approach to learning the discipline: they trade real stocks with real money in real time as they hone their skills.

These traders correctly identify that regardless of the overall accuracy in their trading strategies, they will have ups and downs. However, when explaining long-term failures, they continue to cite a lack of mastery of emotions, without suggesting the possibility of the alternative explanation: a strategy that just doesn’t work. Although these traders are not following a precise algorithm, they could be, if only they were able to define their trading strategy with sufficient precision. The “emotions” factor could then be taken out of play, and the traders could see whether their algorithms were viable from a back testing approach: they would apply their algorithms to a large sample of past situations to see how their portfolios would have performed with fear and greed outside of the picture.

It’s not true that favorable back testing guarantees positive future performance, but it is highly probable that in day trading, back testing that yields negative results implies that the algorithm would not perform well in the future. Yet no time is spent on initial back testing to weed out poor strategies; instead, these strategies are first tested in real time over a span of costly years.

If these traders really wanted to see whether discipline was at the heart of the problem, they could still do it – but they don’t, because it is both emotionally and mathematically challenging to embark on an attempt to disconfirm their hypotheses. However, if only they sought to disconfirm hypotheses from the start, before they became so invested in them, then alternate hypotheses showing more promise could have been tested over the years.

In day trading, periods of success are overly attributed to evidence that the strategy works, and periods of failure are attributed to failure in application of the strategy. The strategy itself is kept insulated from criticism. And because of the difficult in separating the signal from the noise, the illusion easily persists.